Capital Perspectives: Crisis in Turkey

Emerging market stocks have come under considerable pressure recently, with the MSCI Emerging Markets Index having just entered a bear market (defined as a decline of 20 percent from a recent high). Primary drivers of this sell-off have been Turkey and Argentina, which have considerable problems on their hands. Since Argentina has agreed to the terms of an IMF bailout, they are of much less systemic risk than is Turkey, whose leader, Recep Tayyip Erdogan, will likely require a lot more economic pain be inflicted on his citizens before submitting to the type of austerity and reforms that are required to receive bailout funds.

Severe events in the past, most recently the Financial Crisis, have conditioned investors to fear “contagion” when major problems pop up for a certain geography or industry. However, contagious events are low-probability, high-impact outcomes. Trouble brews all over the world, all the time, but rarely results in contagion. Low-probability, high-impact outcomes should be insured against (i.e. we insure our homes, cars and lives), but should not be primary considerations in making investment or life decisions. For our purposes, probably the best insurance one can carry is a healthy dose of high-quality bonds within a balanced allocation.

While other emerging markets share some of Turkey’s characteristics, Turkey appears unique in both the number and scale of its problems. The country exhibits large current account deficits (reliant upon external capital), large trade deficits (imports exceed exports), a large amount of corporate debt denominated in foreign currencies, enormous external debts (large foreign holdings of a country’s debt make it more vulnerable to shocks), a rapidly declining currency, well-above-peer inflation, cockamamie monetary policy and few true allies. Below I utilize several exhibits from an Aug. 15 Wall Street Journal article by Josh Zumbrun entitled “Turkey’s Economic Red Flags Stand Out Among Emerging Markets” to illustrate some of the prior points.

India’s situation may appear more problematic than Turkey’s based on the graph below of select emerging market current account deficits until you consider that India’s economy is three times the size of Turkey’s!

Turkish corporations with large amounts of debt denominated in U.S. dollars and euros will have a difficult time servicing those loans since their revenues come mostly in the now significantly depressed Turkish Lira. The quick deterioration in Turkish corporate creditworthiness is serving to destabilize the country’s banking system.

Turkey’s cockamamie monetary policy is a result of the country’s president stripping the central bank of its independence and instituting his belief that high interest rates cause inflation. Both common economic sense and empirical evidence say otherwise, as do recent inflation readings…

Bottom line, the current route in emerging market assets may well result in a contagious episode like the late-1990s “Asian Contagion,” but a reasonable case can also be made that the major damage can be contained in truly crisis-stricken countries like Turkey. As such, U.S. investors should at least consider to what degree “home bias” plays a role in their allocations now. While U.S. stocks make up only about 50 percent of global equity capitalizations (Developed Markets Ex. U.S. and Emerging Markets comprise roughly 40 percent and 10 percent respectively), studies have shown that U.S.-based investors carry much closer to 100 percent of their portfolios in the shares of domestic companies, missing out on an easy diversification opportunity.

This column has been prepared by an employee of Meliora Capital, LLC. This column is for information and illustrative purposes only. It is not, and should not be regarded as investment advice or as a recommendation regarding any security mentioned herein. Opinions expressed herein are current opinions as of the date appearing in this material only and are subject to change without notice. Reasonable parties may disagree about the opinions expressed herein. The representations made in this column are based upon publicly available information and assumptions about future economic variables which may or may not be reflective of actual occurrences. Meliora Capital, LLC its employees or affiliates may have an economic interest in the securities identified herein.

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One comment

Sadly, when these articles about Turkey-related matters appear in our mainstream English language media, there in no mention of Turkey’s aggressive foreign policy, such as its continued occupation of a third of the nation of Cyprus and its threats to other neighbors.